Exposed?

Private equity, already crippled by the credit crunch, could find itself squeezed by the subprime meltdown in yet another way, namely, declining contributions from the state-run pension plans. However, even as more and more states report budget deficits, private equity pros say the problem may not come from the shortfalls themselves, but rather — more indirectly — from increasing signs of a recession and a sputtering stock market.

The state budget strains can be largely attributed to the expected loss of tax revenue from plummeting home values. Besides California, whose budget problems are well documented, states such as Rhode Island, Massachusetts, New York, New Jersey and Washington can be added to the list of those experiencing shortfalls.

Logic would decree that as budget gaps materialize, the money being set aside for private equity investments would vanish.

Consider Florida. The state relies heavily on real estate to fuel its economy, meaning the subprime crisis and its fallout hit the state especially hard. Things came to a head during a two-week stretch at the end of November, when its state-run investment fund lost $13 billion as panicky local agencies withdrew their assets en masse as soon as they learned of the fund's $2 billion investments in subprime.

But the rules that dictate these funds vary from state to state. In Florida, the state fund acted much like a money market account, allowing the local agencies to contribute and withdraw money as the need arose. PE investors, though, say Florida is an isolated case.

"Pension funds are quite separate from the state budget," says D. Brooks Zug, senior managing director at private equity fund-of-funds investor HarbourVest Partners. He explains that for many states, these funds are investing from their own resources, which are completely isolated from the budget.

Funds such as the California Public Employees' Retirement System (CalPERS), for instance, make it much more difficult for money to be pulled out of the capital pool. Moreover, the asset class has been kind to CalPERS, so the pension is even less inclined to back away.

"Private equity has constituted double-digit returns for the last several years," CalPERs spokesman Clark McKinley, describes, further noting that the pension, in December, increased its allocation from 6% to 10 percent.

A public impact

Even as CalPERS ups its allocation, to a certain degree PE fundraising is beholden to the rest of the pension's non-private equity part of the pie. And CalPERS, much like other state pensions, has more than half of its capital dedicated to public stocks. Hence, a significant decline in the stock market means that capital available for alternatives evaporates as well.

"The stock market has a big influence [on fundraising]," one institutional investor describes anonymously. "Most of these guys are pegging their alternatives allocation to their public holdings. If that denominator is falling, that will impact the numerator."

HarbourVest's Zug echoes that in a lot of cases, the woes of the public market have already had an impact. "Portfolios of public stocks have probably declined by 10% at least," he says. "If that makes up a large part of their total assets, then their total-asset decline will increase [the allocation] of private equity."

When that happens, Zug notes, it forces pensions to be over-allocated, and the typical response is that "they may retrench a little."

With that said, a benefit in favor of private equity is that it's counter-cyclical. As stock prices plummet, PE investors capitalize on depressed valuations. And if the pensions have nowhere else to invest capital, PE's long-term nature provides an appealing outlet.

And Zug notes that if it can be helped, institutional investors should resist moving out of the asset class. "The time to be cutting back was a year, or two years ago [during the M&A boom]," Zug says. Today, he notes that some institutional investors may be growing wary amid the credit crunch and potential economic pullback. But he stresses that it's not advisable for LPs to walk. "History has told us over and over again that it's not the time to be cutting back."